1. Field of the Invention
The present invention relates generally to methods of doing business and, more specifically, to a method of optimizing both market and institutional risks in foreign exchange hedging.
2. Description of the Related Art
Institutions are frequently subjected to foreign currency exchange risks anytime a contract involving future flows of money between countries is entered into. The typical approach to measuring and acting upon foreign currency exchange risk involves a combination of management judgment, techniques like value-at-risk (VaR), and other methodologies known in the art. Usually these different approaches are combined in an ad hoc manner that does not necessarily produce the best result in terms of a hedging (risk reduction) strategy.
Institutions such as corporations that typically sell their products on an international basis must deal with the risks associated with future currency exchange rate changes. A variety of market instruments, such as forwards and options known in the art, enable an international corporation to reduce its foreign currency exchange risk. Typically, international corporations use methods including senior management judgment, value-at-risk (VaR), and other techniques to determine the amount of risk they are willing to undertake given an amount of potential cost or expected return. These approaches all suffer disadvantages of one sort or another.
Management judgment will typically include factors like to what extent losses on the hedging instruments themselves will imperil the future existence of the hedging or risk reduction program. Management judgment also considers whether locking in a particular future currency exchange rate with a forward contract would, through higher local prices, adversely affect the competitive position in that country. Management judgment, although frequently good for an individual currency pairing, usually fails to include expected correlations in movements between numerous other currency pairs.
Value-at-risk (VaR) methods known in the art generally include forecasts for these correlations, so that a corporation's entire foreign currency exchange exposure can be treated holistically. However, these VaR methods do not typically include the type of information cited above under management judgment.
Among the main concerns of most hedging strategies is the reduction of aggregate risk to the institution, while keeping the losses of the hedging itself within some limits. As a result, it is desirable to provide a method of optimizing both market and institutional risks in foreign exchange hedging. It is also desirable to provide an optimization framework for evaluating the risk of different hedging strategies using foreign currency exchange forwards.